Chapter 14 Financial Statement Analysis

Who and Why?  To understand the economics of a firm and  To help forecast its future profitability and risk Profitability is an increase in wealth Risk is the probability that a specific level of profitability will be achieved.  Managers Responsible for day to day operations and and long-range performance Responsible and accountable for efficiency, effective deployment of capital, human resource and other resource management  Owners Interested in current and long-term returns on their investments Expect growing earnings, dividends Affected by how earnings are distributed and how their shares are valued in the market  Lenders and creditors Concerned about liquidity and cash flow of the company Interested in the degree of financial leverage employed  Others: employees, government, society

Financial Statement Analysis  Should start with an understanding of Global and local macro economic condition Industry (past performance, future expectations, competition etc…)  Should involve time series analysis,  Should compare performance with peers, competitors, industry averages

Tools  Analytical Analysis Vertical Analysis Horizontal Analysis  Ratio Analysis

Analytical Analysis Vertical Analysis  Express the items in the financial statements as a percentage of total assets or sales

Income Statement- Vertical Analysis

Balance Sheet Vertical Analysis

Trend Analysis

Ratio Analysis  Important point: to be selective-too many ratios would lead to information overload  Understand the meaning and limitations of the ratios  Define the following elements before starting: The viewpoint taken The objectives of the analysis The potential standards of comparison  Remember ratios are not absolute: they are relative performances over time, over a number of companies, over an industry, etc.  Ratios might indicate changes in patterns and help to assess future risk of the company in question

Usefulness of Ratios  Help compare different firms, and  Help compare the firm against its past performance  Standards against which to compare ratios 1. The planned ratio for the period 2. The corresponding ratio from a prior period 3. The corresponding ratio for another firm in the same industry 4. The average ratio for other firms in the same industry

Ratio Analysis  Cross-sectional and time series analysis  Controls for size differences  Controls for currency differences  Evaluate related components of different financial statements simultaneously  Ratios are easily (and commonly) modified

Ratio Analysis Categories  Activity (operations and asset management)  Liquidity (meeting short-term obligations)  Solvency (meeting long-term obligations)  Profitability (earnings and cost coverage)  Cash Flow (quality of earnings)  Price Multiples (stock price)

Activity Ratios  Receivable turnover  Average collection period

Activity Ratios  Inventory turnover  Average days in inventory

Activity Ratios  Payable Turnover  Average payment period

Activity Ratios  Cash Cycle:

Activity Ratios  PP&E Turnover  Asset Turnover

Liquidity Ratios  Current ratio Ability to meet short-term obligations [Current assets/current liabilities]  Quick ratio Remove less liquid assets Keep cash, liquid investments, A/R [(Cash+short-term investments + A/R)/current liabilities]

Solvency Ratios  Debt to assets: Total liabilities/Total assets Proportion of assets financed with debt  Could include interest bearing debt only [(short term debt + noncurrent debt)/total assets]  Be aware that assets are recorded at historical cost, which may be different from current market value

Solvency Ratios  Debt to equity: Total liabilities/Total equity A measure of how assets are financed

Solvency Ratios Coverage Ratios  Adequacy of resources for meeting firm’s contractual obligations  Times interest earned Can the firm cover its interest obligations? (EBIT/Interest expense)  Cash interest coverage (Cash from ops + interest paid + tax paid)/Interest paid

Profitability Ratios  Gross Margin: profitability of sales  Return on Sales: Net profitability of the company

Profitability Ratios  Retun on Assets  Return on Equity

Cash Flow Ratios Quality of earnings  Ability to pay obligations CFO/Total liabilities CFO = Cash flows from operations  Profitability (cash flow relative to sales) CFO/Sales revenue  Cash flow-earnings index CFO/Net income

Price Multiple Ratios  Market’s valuation of a firm’s common stock P/E = Share price/Earnings per share  Price/book ratio compares stock’s price to the recorded value of the net assets [Share price/(Book value of equity/Share outstanding)]

Limitation of Ratio Analysis  Represent the average conditions and influenced by the accounting methods used  Based on historical data and do not reflect price level effects and real economic values  Changes in many ratios are strongly associated with each other and interrelationships among/between the ratios should be examined  During comparison of ratios over a period of time changes in operating conditions should be taken into consideration  During comparison between companies differences among the companies should be examined  Use audited financial statements to perform ratio analysis